Tuesday, May 27, 2008

Soros: Skyrocketing Oil Prices a Bubble

Veteran investor George Soros, in an interview with the Telegraph, describes speculation as a significant factor in the recent spike in oil prices. However, he doesn't expect prices to break until there are signs of economic weakening. Later in the post, I'll provide some information that suggests how traditional supply/demand forces could have been swamped by the volume of futures trading.

Speculators are largely responsible for driving crude prices to their peaks in recent weeks and the record oil price now looks like a bubble, George Soros has warned....

...Now let's consider how Soros' argument might be correct. In general, the notion that spot prices accurately reflect supply an demand is a bit overdone. As Matthew Simmons noted in 1998:

In our opinion…prices over the short-term tell us nothing about the supply and demand fundamentals for oil. Rather than being a perfect indicator for the fundamentals, price is a perfect indicator for the psychology of a small number of funds.

There are two arguments made against the speculation thesis. One is arbitrage: if oil was too high, someone would go short the future and buy oil in the cash market cheaper, and earn the arbitrage profit.

The problem with that logic is that price discovery happens in the futures markets; there isn't another venue for setting the price and thus arbitraging it against futures. Worse, a substantial amount of that trading is either over the counter (hence not reported to US futures regulators) or on the ICE exchange in London (ditto)....MORE